Thursday, February 8, 2018
The Spousal Qualified Joint Venture – Implications for Self-Employment Tax and Federal Farm Program Payment Limitations
As noted in Part 1 of this two-part series on the spousal qualified joint venture (QJV), some spousal business ventures can elect out of the partnership rules for federal tax purposes as a QJV. I.R.C. §761(f). In Part 1, I looked at the basics of the QJV election and how it can ease the tax reporting requirements for spousal joint ventures that can take advantage of the election. Today, in Part 2, I look at how the election impacts self-employment tax and, for farmers, eligibility for federal farm program payments.
The QJV Election and Self-Employment Tax
Under I.R.C. §1402(a), net earnings from self- employment are subject to self-employment tax. Net earnings from self-employment are defined as income derived by an individual from any trade or business carried on by such individual. But, real estate rental income is excluded from the general definition of net earnings from self-employment. I.R.C. §1402(a)(1). Thus, for rental property in a partnership (or rental real estate income of an individual), self- employment tax is not triggered.
The QJV election and rental real estate. I.R.C. §1402(a)(17) specifies that when a QJV election has been made, each spouse’s share of income or loss is taken into account as provided for in I.R.C. §761(f) in determining self-employment tax. I.R.C. §761(f)(1)(C) specifies that, “each spouse shall take into account such spouse’s respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor.” That means that the QJV election does not avoid the imposition of self-employment tax.
However, the exception from self-employment tax for rental real estate income remains intact. The IRS instructions to Form 1065 state that if the QJV election is made for a spousal rental real estate business, "you each must report your share of income and deductions on Schedule E. Rental real estate income generally isn’t included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive loss limitation rules. Electing qualified joint venture status doesn’t alter the application of the self-employment tax or the passive loss limitation rules.” See also CCA Ltr. Rul. 200816030 (Mar. 18, 2008).
While the QJV election may not be a problem in a year when a loss results, the self-employment tax complication can be problematic when there is positive income for the year. That’s because it is not possible to simply elect out of QJV treatment in an attempt to avoid self-employment tax by filing a Form 1065. The QJV election cannot be revoked without IRS consent. Likewise, it’s probably not possible to intentionally fail to qualify for QJV status (by transferring an interest in the business to a non-spouse, for example) to avoid self-employment tax in an income year after a year (or years) of reducing self-employment by passed-through losses. Such a move would allow IRS to assert that the transfer of a minimal interest to a disqualified person or entity violates the intent of Subchapter K
Tax Reporting and Federal Farm Program Participation - The "Active Engagement" Test
For farm couples that participate in federal farm programs where both spouses satisfy the “active
engagement” test, each spouse may qualify for a payment limitation. 7 U.S.C. §§1308-1(b); 1308(e)(2)(C)(ii); 1400.105(a)(2). To be deemed to be actively engaged in farming as a separate person, a spouse must satisfy three tests: (1) the spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation; (2) the spouse’s contributions must be “at risk;” and (3) the spouse must make a significant contribution of capital, equipment or land (or a combination thereof) and active personal labor or active personal management (or a combination thereof). For the spouse’s contribution to be “at risk,” there must be a possibility that a non-recoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor or management must be material to the operation to be “significant contribution.” Thus, the spouse’s involvement, to warrant separate person status, must not be passive.
While the active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. That’s because, the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.
What this all means is that for spouses who sign up for two separate payment limitations under the farm programs, they are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear risk of loss.
From a tax standpoint, however, the couple may have a single enterprise the income from which is reported on Form 1040 as a sole proprietorship or on a single Schedule F with the income split into two equal shares for self- employment tax purposes. In these situations, IRS could assert that a partnership filing is required (in common-law property states). That’s where the QJV election could be utilized with the result that two proprietorship returns can be filed. As mentioned above that’s a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return. But, the filing of the QJV election will subject the income of both spouses (including each spouse’s share of government payments) to self-employment tax. That will eliminate any argument that at least one spouse’s income should not be subjected to self-employment tax on the basis that the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for self-employment tax purposes).
Separate “person” status and material participation. Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction is meaningless on the self-employment tax issue according to the U.S. Tax Court.
In Vianello v. Comr., T.C. Memo. 2010-17, the taxpayer was a CPA that, during the years in issue, operated an accounting firm in the Kansas City area. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant would deduct the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one- third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002. Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions with respect to raising and marketing the crop, and paid the petitioner one-third of the net proceeds. As for the pasture, the tenant mowed it and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. Also, the petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003, and bought another 50 acres from in late 2003.
The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year - as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on a reading of IRS Pub. 225 (Farmer’s Tax Guide) that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda grass planting with the tenant. The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules as having satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical cost.
The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active engagement test and was a co- producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…”. The Tax Court specifically noted that the Treasury Regulations under I.R.C. §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard” [emphasis added]. That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or self-employment tax purposes. As noted below, however, the USDA’s determination of participation is not controlling on the IRS.
Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented, and provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for self-employment tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for self-employment tax purposes. The case may also support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes. But that is probably a weaker argument – Vianello did not involve a spousal farming situation.
So, while Vianello may eliminate the need to make a QJV election in spousal farming situations, without the election it is possible that IRS could deem spouses to be in a partnership triggering the requirement to file a partnership return.
The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. That includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. But, the election does not eliminate self-employment tax on each spouse’s share of income.